Monday, September 17, 2012

Rabobank on Financial Repression and What Bernanke is Up To

This report is nine months old but worth the read. The analysts give a straightforward discussion of financial repression with but one failing, they didn't foresee how much emphasis Chairman Bernanke would place on "transparency" i.e. jawboning the market into giving up the low-inflation expectation anchoring that has been assiduously nurtured by the Fed for the last 25 years.

I'm open to the idea that all the jobs talk and jobs targeting is just the magicians favorite tool, misdirection, while the actual trick is being performed in plain sight.We'll see.
In the meantime some very smart people are gaming all this on some very fast computers and coming up with a whole bunch of effects on rates, spreads, swaps and Grandma's savings account.

From Rabobank, December 2011:

Special Report

Risk of financial repression in the West

This article is part of a series of Special Reports that discuss the downside risks to the global economic outlook. In this piece, we take a closer look at the risk of financial repression in the West.

Budget cuts are politically unpalatable Many governments in the industrialised world are stuck between Scylla and Charybdis– the two famous sea monsters in Greek Mythology. If they are to cut their primary budget deficit too quickly to please the market, they risk choking the fragile recovery, if they do it too slowly, they risk falling into the ‘bad’ equilibrium of rising interest rates and lower growth. In both cases, the incumbent government will have difficulty winning the upcoming elections.

History shows that boosting real GDP growth in a period of sluggish domestic and external demand is next to impossible. So how else can a government lower its debt ratio? One solution touted by market participants is making sure the nominal interest rate the government pays on its long-term debt stays lower than the growth of nominal GDP. By keeping the interest rate – growth differential (IRGD) negative, the debt ratio starts to fall, ceteris paribus.

But how can that be achieved? Since boosting real GDP growth is out of the equation, inflation must rise to push nominal GDP growth upwards. Yet if inflation starts to rise, bond vigilantes will rightfully demand an interest- rate premium. Of course, the effective nominal interest rate on the debt is slow to respond to an increase in market yields because the entire debt stock does not roll over every period. But in due time all the debt stock will have to be serviced at higher interest rates. As you can imagine, all the government will achieve is moving from a low inflation/interest rate equilibrium to high inflation/ interest rate equilibrium while the IRGD stays unchanged. This does nothing to improve debt sustainability.

But the study of Escolano et al. (2011) shows that during 1999-2008, IRGDs in the nonadvanced economies, on average, have been deep into the red (below -7%-points). Reinhart and Sbrancia (2011) also find that during 1945-80, governments in the advanced economies managed to significantly liquidate their debt ratios via negative real interest rates. For example, the annual liquidation effect in Australia, Italy, the UK, and the US was estimated to be between 3-5% of GDP (see figure x).....MORE (5 page PDF)